Friday, 25 November 2011

The End of Leverage

We are clearly present in an era of great unwinding. In financial terms, we could call it the end of the Age of Leverage. In simpler, ordinary terms, it’s the great unwinding. The unwinding of the trust which underpinned the great political experiment of the Eurozone. The unwinding of the social contract between the baby boomers who put the West together after World War II, only to see their pensions and healthcare systems collapse. The unwinding of the idea that any family could aspire to buy a house in a real estate market with 5-7% per year appreciation and loans 20-30 times their annual salaries. The unwinding of 80% debt:GDP ratios, which were formerly considered ‘safe’.

This moment has been a long time coming, but the previous time it occurred was probably on October 29, 1929, on ‘Black Tuesday’ which marked the Great Crash and ushered in the Great Depression.

We’ve had crashes since then, notably the 1979 oil price shock, the 1988-1990 savings and loan scandals, the 1999 dot.com crash, and the 2008-2009 financial crisis. But until now, these were either sectorally- or geographically-isolated, and none of them led to a serious challenge of the status quo.

The current crash is markedly different: We are experiencing the simultaneous, synchronised downturn of public sector/sovereign debt, commercial/residential real estate, and personal (household) debt. The latter is perhaps the most overlooked, but it is clear from multiple markets that the greatest long-term economic impact will be on reduced household expenditure.

Why is this occurring? For a number of reasons. First of all, the “West’s” (a term I will use loosely to describe the United States and most of Europe) economic competitiveness is in dramatic decline for the broad majority of the population. We see this in the dramatic worsening of the trade balance in manufactured goods in most Western countries, as well as in rising unemployment, declining birth rates, and an ageing society. This means that most Western consumers consume more imported products (often on credit), but have fewer high-paying jobs to sustain their lifestyle.

Second of all, global capital and manufacturing is now too delocalised, or globalised, to count for much in terms of traditional measures of national economic activity. Apart from a few “commanding heights” industries, which today arguably includes innovative IT and financial firms as well as strategic industries, the balance of trade works in favour of multinational enterprises and against national governments in most countries. Hence the rise of offshore centres such as the Cayman Islands , Hong Kong or Switzerland, which will emerge stronger from the crisis. Hence the fact that in most countries, salaried employees now typically account for 75% of tax revenue, versus 25% from companies.

Third of all, the fact that the West has moved from a manufacturing to a service-based economy also means that (a) employment is lost through productivity, and (b) services are increasingly offshored. This means that most wages for average service jobs continue to decline. We see this reflected in declining real incomes in nearly every country.

These fundamental challenges to economic competitiveness have been concealed in the West by a number of factors:

a.Financial deregulation and the investment of surplus savings from countries such as China or Saudi Arabia has meant that the average consumer could borrow unprecedented amounts of money on a very low asset or income base. The idea, for instance, that an average Greek or American consumer could be given a credit card with a credit limit of 25% his annual after-tax income, and then receive additional credit cards, beggars belief. Yet it is common practise.

b.The growth of a global financial industry headquartered in the United States and the United Kingdom meant that for these two countries, overall GDP numbers were “massaged” by financial sector performance, concealing declines in a number of other areas. The intimate links between the financial sector and the political finance system also meant that no meaningful reform was, or is, possible.

c.Surplus capital and the end of individual credit limits meant that real estate and property development became relatively easy, leading to a boom, and subsequent bust.

d.State-led development has retained its primacy in most markets, largely because the state could afford to exchange political favours (such as employment or contracts) in exchange for continued power. This is seen perhaps clearly in the United States, where the political finance and military budgets remain immune to common sense, or in Europe, where the concept of “social democracy” has led to a massive increase of government regulation and state apparatus in nearly every domain conceivable. It’s a common problem, but its manifestation differs from country to country.

The end of these runs now means that a number of fundamental problems remain to be addressed. A critical issue is the impact on population aging, as well as in multiculturalism. European societies, for instance, have changed massively in terms of culture in the last 30-40 years, driven by Islamic and African migration, urbanisation, and the end of formerly mono-cultural societies and religions. It remains to be seen whether these societies will retain the cohesion necessary to continue in their present geographic form. Aging populations not only challenge cohesiveness, but they threaten to tear apart the social contract and the pay-go social insurance system.

Taken together with increasing austerity, an end to state benefits, and a continuing economic decline for the average taxpayer and consumer, it is clear that we are entering territory familiar perhaps in 1930, but unknown in our times.

What can we forecast for the next 10 years?

It seems hardly likely that the financial systems and sovereign debt systems will remain intact in the midst of this market crisis. Europe’s funding needs are simply too large to be met entirely by the existing private sector. Either there will be a move towards the creation of a European Federal Reserve, with the power to print money, or there will be a break-up of both the Eurozone and the banking system. Either way, it is clear that the role of the state in the economy in most European countries will shrink, as it will in the United States. This is not to say that privatisation will offer any meaningful solutions: it is simply to confirm that given demographic and economic change, the state can no longer afford its current and future liabilities, and can no longer borrow money from external sources either.

It means that the average voter and consumer will deleverage to a massive extent. This will either take place due to an aversion to incur more debt, or to a foreclosure process that will seize his or her assets. This means that EUR 660 Apple iPhones or EUR 6 Starbuck’s coffee will soon be a thing of the past. It also means that McMansions and the practise of 30-year mortgages will end as well.

And finally, it means the inevitable rise of nationalism, xenophobia, and the political return to an imagined, idealised past. Who would have thought that the bouffant hair and wide shoulderpads of the 1980s or the grunge of the 1990s would one day be synonymous with the Roaring 20s? Yet that is almost inevitably what will happen. The entire Republican Party’s platform in the United States is based on this. In Europe, the rise of the ultra-right is merely a different symptom of it.

We are almost certainly going back to another form of protectionism. Tariffs on manufactured goods and finance will be levied. Restrictions on immigration will come back into place. The “new rich” of Brazil or China will be tolerated, so long as they are discrete, and they spend. There will almost certainly be a political and popular backlash against certain ethnic or religious groups within certain countries.

What does this mean for the average worker? Further declining incomes and lower job security. Less access to public benefits such as public health, housing loans or retirement. Longer working lives, and longer working hours within these.

There are at least three wild cards in this relatively bleak outlook, and I’m almost sorry to mention them. The first concerns the demographic changes we are seeing will lead to an increase in mortality of the baby boomer generation in the next 10-15 years. This means that, for some people at least, their relative paucity of present economic benefit will be supplemented by inheritance. It also means that Western governments will benefit, as they will naturally tax this inheritance to the best of their abilities.

The second wild card is that of foreign investment. It is entirely natural that as asset values in the West decline, there will be increased investment from abroad. There will also be investment fleeing to the relative “safe havens” that may remain. Whether this will be greeted with friendship or xenophobia remains to be seen, but it is clear from present trends that in the next 10 years, Europe is set to receive hundreds of thousands if not millions of Chinese and other Asian investors, but temporary and permanent residents. How Europe deals with this will be instructive.

The third wild card is that of political instability in the face of changing expectations and rising population growth. We should not expect China to retain its monolithic internal political control without a massive struggle. Moreover, we should not expect the rise of China to be peaceful. There are hardly any examples in history of a peaceful empire rising, and China’s rise to date has not been peaceful either.

This is the End of Leverage. The end of our confidence in debt and in a positive future. The return to self-reliance, thrift and far less conspicuous consumption. In many countries, the average family will spend the next 2-3 years dealing with basic economic survival in the face of a crumbling financial, government and social system. It will be an age of McDonald’s rather than an age of Starbuck’s and for all-too-many people, it will be the age of Tom Joad rather than that of Jay Gatsby.

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